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In the Financial Secretary's 2020 – 2021 budget
speech, the Hong Kong Government announced that it will consider
extending the anti-money laundering/counter terrorist financing
requirements to cover crypto currency service providers. This marks
the latest move of the city's regulation of cryptocurrencies,
which have been classified as virtual assets and have been
primarily regulated by the Securities and Futures Commission of
Hong Kong ("SFC").

Initially, virtual assets only came within the SFC's regulatory regime if their terms of
issuance resembled those of "securities", or their
trading fell within the confines of "futures contracts".
Started in November 2018, the SFC
extended its oversight of virtual assets and their service
providers by tackling the management and distribution of virtual
assets. This is followed by its position paper in November 2019
which sets out a new regulatory framework for virtual asset trading
platforms ("VA Platforms"). The new
regulatory standards are comparable to those applicable to
traditional licensed securities institutions, and apply to VA
Platforms to the extent any of the virtual assets being traded
amounts to "securities" or "futures
contracts".

Whereas public consultations on the extension of AML/CTF requirements to virtual assets will
commence later this year, this alert highlights the SFC's licensing requirements on VA
Platforms, the new regime's reception by industry players and
some other notable recent developments.

VA Platforms

Most cryptocurrencies, such as Bitcoin and Ether, are not
"securities" as defined in the Securities and Futures
Ordinance (Cap. 571) ("SFO"), and thus outside of the
SFC's regulatory remit. One notable
exception is, where virtual assets take up more than 10% in a
fund's portfolio, the management and distribution of such funds
are subject to additional SFC
requirements.

Similarly, VA Platforms that only trade in non-security crypto
assets are not required to be licensed by the SFC. It follows that a prerequisite for
licensing is that the VA Platforms must trade at least one crypto
asset which is a security (i.e. a security token). Such VA
Platforms would then fall within the jurisdiction of the SFC and require a licence for Type 1 (dealing
in securities) and Type 7 (providing automated trading services)
regulated activities.

The SFC requires that a VA Platform
operator to ensure that all virtual asset trading business
activities carried out by its group of companies and the active
marketing of such trading services to Hong Kong investors must be
conducted by one group entity under a single licence. Once the VA
Platform is licenced with the SFC, its
entire trading business activities, be it trading of security
tokens or non-security tokens, will be subject to the SFC's oversight.

Licensing Conditions

In order to qualify for a license, the applicant must:

a. only provide services to professional
investor as defined under section 1 of Part 1 of Schedule 1 to the
SFO. "Professional investor"
includes specified entities set out in subsections (a) to (i) of
the definition (such as banks and insurance companies) and persons
belonging to a class which is prescribed under subsection (j);

c. obtain SFC's
prior written approval for any plan or proposal to (i) introduce or
offer a new or incidental service, or activity, or (ii) to make a
material change to an existing service or activity;

d. provide monthly reports to the SFC on its business activities in a format as
prescribed by the SFC; and

e. engage an independent professional firm
acceptable to the SFC to conduct an
annual review of its activities and operations and prepare a report
confirming that it has complied with the licensing conditions and
all relevant legal and regulatory requirements.

Key requirements under the Terms and Conditions

In addition to the existing requirements applicable to other
traditional licensed intermediaries, the Terms of Conditions has
provided specific requirements in the context of virtual assets.
Some of the key features are as follow:

Financial soundness

The licensed VA Platform must maintain at all times
sufficiently liquid assets, equivalent to at least 12 months of its
actual operating expenses calculated on a rolling basis

Submission of legal advice

The licensed VA Platform should obtain and submit to the SFC written legal advice in the form of a legal
opinion or memorandum on the legal and regulatory status of every
virtual asset that will be made available in Hong Kong, in
particular, whether that virtual asset falls within the definition
of "securities" under the SFO

The licensed VA Platform should exercise professional
scepticism before relying on any legal advice, and review such
advice with due care and objectivity

Custody of virtual assets

Client assets (virtual assets and client money) must be held on
trust through an associated entity in a segregated account

Not more than 2% of the client virtual assets can be stored in
hot wallets, and at least 98% of the virtual assets must be kept in
cold wallets. Storage in a "cold wallet" refers to the
private keys which are kept offline, and therefore provide more
security

An insurance policy covering risks associated with the client
virtual assets must be in effect at all times

Know-Your-Client

The licensed VA Platforms must ensure that the client has
sufficient knowledge of virtual assets and their associated
risks

If a client does not possess such knowledge, the licensed VA
Platform may only provide services to the client after providing
training to the client and enquired into the client's personal
circumstances

AML/CFT

The licensed VA Platform must employ effective procedures and
controls, such as virtual asset tracking tools which enable it to
trace the on-chain history of specific virtual assets, to manage
AML/CFT risks

Limitations of the regulatory regime

Unless and until the SFO is amended,
the current legislative framework does not enable the SFC to take action against market misconduct
committed by a licensed VA Platform, because it is not a recognized
stock or future market and the virtual assets are not
"securities" or "futures contracts" listed or
traded on such a market. Also, there are no mandatory disclosure
requirements applicable to an offer of non-security virtual
assets.

Furthermore, the new regulatory regime applies only to
centralised exchanges (i.e. where the VA Platforms have control
over investors' assets) and not to decentralised exchanges on
which many cryptocurrency investors trade on a direct peer-to-peer
basis.

Warnings on virtual asset futures contracts

When issuing the Position Paper, the SFC also issued a warning on virtual asset
futures contracts, emphasizing the extremely risky and volatile
nature of such derivatives products. Any trading platforms or
persons which offer/or provide trading services in virtual asset
futures contracts, without a proper licence or authorization, may
contravene the SFO and/or the Gambling
Ordinance (Cap. 148).

In any event, the SFC stated that it
would be "unlikely to grant a licence or authorisation to
carry on a business in such contracts".

Public reception of the new regime

There are gives and takes for VA Platforms to opt in to the
SFC's new regime. While they can
boost investor confidence that assets held by licensed VA Platforms
will be safeguarded by SFC's
stringent procedures and measures, the new regime applies only to
centralised exchanges, where investors do not have direct control
over crypto funds. This means trading virtual assets through
licensed VA Platforms could potentially eliminate some of the
benefits of dealing in virtual assets itself (such as anonymity) in
light of SFC's recommendation to
deploy virtual asset tracking tools for AML purposes.

In addition, the requirements to operate as a single legal
entity for licensing purposes, and the restriction against
servicing non-professional investors, could potentially limit the
scope of business and target clients.

In light of the above, it is not surprising that public
receptions to the new regulatory regime are quite diverse. Since
launching the VA Platform licensing regime last November, the SFC has received a number of licence
applications from several institutional VA Platforms, including
HashKey Group and BC Group. Those who are enthusiastic about the
licensing opportunity believe that it can step up constructive
oversight in the region and enhance investor confidence in FinTech,
blockchain and digital asset industries.

However, there have been voices from the industry that played
down the importance of the new licensing regime. They claimed that
the new regime is redundant, as most VA Platforms in Hong Kong
focus on offering liquidity for non-security tokens, such as
Bitcoin and Ether (ETH) rather than those
security tokens that are regulated. Others have expressed concerns
that, even if licensed, banks in Hong Kong may remain unwilling to
open accounts for business areas they don't want to service,
because of the uncertain or costly AML/CTF compliance requirements. Indeed, the
Bitcoin Association of Hong Kong has identified that banks are
"highly hesitant to open accounts to financial services
companies, and even more so for cryptocurrency
businesses".

It is in this regard that most market players await in earnest
the government's upcoming consultation to clarify and
standardize their compliance obligations, so that virtual asset
service providers can further develop their businesses whether they
want to be licensed by the SFC or
not.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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